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Lumpy Price Adjustments : A Microeconometric Analysis E. Dhyne (NBB, UMH), C. Fuss (NBB, ULB), H. Pesaran (Cambridge U., USC), P. Sevestre (U. Paris I, BdF) The views expressed are those of the authors and do not necessarily reflect the views of the National Bank of Belgium and of the Banque de France. "Price and Wage Rigidities in an Open Economy" National Bank of Belgium - Brussels, October 12-13, 2006

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PP 2 Introduction Empirical analysis of the sources of price stickiness: nominal vs real rigidity Motivation : In modern macroeconomics, price rigidity = source of short-run non neutrality of money Degree of nominal rigidity One of the determinants of the slope of the NKPC

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PP 3 Introduction New strand of empirical work on the evaluation of the frequency of consumer price changes Similar set of stylized facts in industrialized countries Price changes are infrequent US : 25% Bils and Klenow (2004), Klenow and Kryvtsov (2005) Euro area : 15% IPN, Dhyne et al. (2006) Belgium : 17% Aucremanne and Dhyne (2004) France : 19% Baudry et al. (2004) Heterogeneity in price stickiness (oil products => services) Asymmetry: 4 price changes out of 10 are price decreases Price changes are relatively large (around %)

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PP 4 Introduction Main question : whats behind infrequent price changes ? A firm may consider that its more profitable to keep its price constant between two periods because of large price adjustment cost: nominal rigidity small volatility of marginal costs / desired mark-up: real rigidity Other questions : Can prices be informative on the degree of "wage" stickiness ? Are asymmetric price changes caused by asymmetric price adjustment costs ?

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PP 5 A canonical model of price adjustment A firm i sets its price at time t based on pricing rule p it = p* it if |p* it -p it-1 | > c it p it = p it-1 if |p* it -p it-1 | c it With p* it the (unobserved) optimal price given as p* it = mc it + it = f t + i + it Common component of marginal cost and desired mark-up Firms specific component heterogeneity in price levels, ability of firm i to set its prices above/below f t Idiosyncratic shock on marginal cost and desired mark-up

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PP 6 Unobserved common component f t Common movement in marginal costs and desired mark-up Estimation by using cross-sectional averages : generalization of Pesaran (2006) to non-linear models where g(f t ) non linear function of f t, p it-1 and other parameters f t only equals to p t when E[c it ] = c = 0 Iterative procedure : estimate f t given estimate given f t Can also be estimated jointly with by ML Both estimation procedures need N and T large Summarize with AR(p):

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PP 7 Sources of nominal and real rigidities p it = p it-1 if |f t + i + it - p it-1 | c it = f t + i + it otherwise Nominal rigidity : Expected value of price adjustment cost c it, c Real rigidity : Unconditional volatility of f t, std(f t ) or volatility of the common shock, Volatility of idiosyncratic shock it,

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PP 8 The Belgian and French CPI data sets Belgian CPI : around individual prices French CPI : around individual prices Prices observed at the retail level from 07/94 to 02/03 Described in Aucremmane and Dhyne (2004, 2005), Baudry et al. (2004) Estimation method : Maximum Likelihood with 1 firm specific random effect ( i ) 98 products (Belgian CPI) / 30 products (French CPI)

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PP 9 Price trajectories: Oranges (Belgium)

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PP 10 Price trajectories: Men socks (France)

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PP 11 Ability of the estimated model to replicate the frequency and size of price changes Good results for 88 products for the Belgian CPI out of 98 Good results for a large set of products : flexible or sticky prices, seasonal, with a trend, regulated or not But bad performance for products with few price quotes / month products where c it highly volatile Model's performance

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PP 12 True data Freq = |Dp| = Simulated data Freq* = |Dp|* = c = = f = Flexible prices : Heating oil

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PP 13 c = = f = True data Freq = |Dp| = Simulated data Freq* = |Dp|* = Seasonal product : Oranges

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PP 14 c = = f = True data Freq = |Dp| = Simulated data Freq* = |Dp|* = Asymmetric sticky prices : Special beer in a bar

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PP 15 c = = f = True data Freq = |Dp| = Simulated data Freq* = |Dp|* = Asymmetric sticky prices : Calculator

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PP 16 Based on 88 Belgian CPI products + 30 French CPI products Average c : 0.35, comparable in magnitude with Levy et al. (1997) based on cost structure of supermarkets. Idiosyncratic shocks always larger than common shocks, except for oil products (Golosov and Lucas, 2003) Main results

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PP 17 Oil products (Freq = 0.75) : small c (0.012), large ω (0.033), small (0.027) flexible Perishable food (Freq = 0.24) : medium c (0.266), large ω (0.028) and (0.098) nominal rigidity Non perishable food (Freq = 0.15) + non durable goods (Freq = 0.16) medium c (0.271 – 0.358), smaller ω (0.016 – 0.019) and (0.076 – 0.086) real and nominal rigidity Durable goods (Freq = 0.08) + services (Freq = 0.06) : high c (0.493 – 0.384), smaller ω (0.015 – 0.013) and (0.079 – 0.054) strong real and nominal rigidity Sectoral heterogeneity

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PP 18 Examples Belgian CPI : Kiwis / Beef Sirloin : freq, c, ω, French CPI : Sugar / Men coat : freq, c, ω, Ratio ( ω ) 0.5 /c KiwisBeef SirloinSugarMen coat Freq c Analyzing the frequency of price changes

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PP 19 OLS regression of the frequency of price changes (1)(2) Const Dummy France c ( ) 0.5 /c N118 R² Analyzing the frequency of price changes

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PP 20 Can prices say something about wage rigidity? (Belgian CPI) 5 product categories for which price = labor cost (hourly rate of a plumber, hourly rate of a painter, hourly rate in a garage, central heating repair tariff, domestic services) Lowest frequency of price changes Lower c than other services (0.3 compared to 0.5) but similar to average perishable or non perishable food, non durable goods Low magnitude of common and idiosyncratic shocks real rigidity is a major source of wage price rigidity Other results: tentative lessons on wage rigidity

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PP 21 Exploring the asymmetry of price changes (Belgian CPI) Stylized fact : price increases are slightly more common than price decreases. Is this associated to stronger downward nominal rigidities ? Baseline model generates asymmetric price changes if f t characterized by a positive (negative) trend ( Ball and Mankiw,1994 ) Estimation of a model of asymmetric price adjustment costs (c up, c down ) for oranges ( % ups = 52 % ) and special beer in a bar ( % ups = 88 % ) Results : c up - c dw statistically significant but not economically relevant Oranges : c dw - c up = Special beer : c dw - c up = Other results: asymmetric price changes

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PP 22 Comparable estimate of the magnitude of price adjustment costs with the existing empirical litterature (Levy et al. (1997)) : average level of c : close to 35% of the price level Idiosyncratic shocks are larger than common shocks. Heterogeneity in the frequency of price changes not only associated to heterogeneity in price adjustment costs but also … … significant contribution of real rigidity Implications for macro models: heterogeneity in the degree of real rigidity (Gertler and Leahy, 2006) Conclusions

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PP 24 Extensions Gradual adjustment When a firm changes its price, it could adjust only gradually to changes in the optimal price : p it = (1- ) p* it + p i,t-1 Adds source of real rigidity : the larger, the more gradual is the response of prices to shocks on marginal costs / desired mark-up Motivation : strategic behaviour of firms, uncertainty about relative importance of common and idiosyncratic shocks Asymmetric price adjustment costs Stylized fact : price increases are slightly more common than price decreases Is this associated to stronger downward nominal rigidities ?

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PP 25 Model with gradual adjustment (Belgian CPI): always significant (t-stat, LR) Only relevant when relatively frequent price changes Heating oil : = Oranges : = Central heating repair tariff : = But biased towards 1 for product with synchronized and infrequent price changes, and for flat price trajectories Hourly rate of a painter : = Other results: gradual adjustment

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